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Thinking About a Home Equity Loan? The Do's and Dont's of Home Equity Loan

Homeowners who have equity might be tempted to extract some of that wealth and use it for other immediate needs or wants.

But should you use a cash-out refinance, home equity loan or home equity line of credit to replace your roof

As Jay Voorhees, broker and owner of JVM Lending, a mortgage company in Walnut Creek, Calif., says, "It all comes down to responsible borrowing."

With that in mind, here's a look at six common home equity cash-out scenarios and why they might—or might not—make sense for you.

Yep: Use Equity to Renovate

Home improvement is "the No. 1 use" of home equity loans and home equity lines of credit, or HELOCs, says Kelly Kockos, home equity product manager for Wells Fargo in San Francisco.

Second on the list are major purchases, which these days are more likely to be vehicles, appliances or other durables rather than lavish weddings or exotic vacations.

The upside is clear if you bought a home you don't completely love and want to remodel, whether that means an addition, cosmetic changes, kitchen and bathroom updates, finishing a basement or building a garage, suggests Justin Lopatin, vice president of mortgage lending for PERL Mortgage in Chicago.

The opportunity is especially attractive if your home has risen in value so you have a larger equity cushion.

"You can leverage that equity at a low rate to improve your home and make it more comfortable," Lopatin says. "If you can tap into equity without increasing overhead to the point that it's not affordable or comfortable for you, that's a good reason."

Maybe: Use Equity to Invest

Home equity can be used to invest for a higher return as long as interest rates remain low, Lopatin suggests.

"It's inexpensive cash. If you can borrow at 4 percent and turn around and make an investment in the stock market and yield 8 percent, you made 4 percent on your money," he says.

Moore says home equity can be a good source of funds to start a business or further your education, but he adds that an objective adviser should be consulted to ensure that your investment is sound.

Maybe: Use Equity as a Student Loan

A HELOC or home equity loan can be an attractive way to finance a child's education because the interest rate might be lower and the maximum loan amount higher than some other types of education financing, says Andy Tilp, president of Trillium Valley Financial Planning in Sherwood, Ore.

But this strategy isn't risk-free.

"I've seen parents struggle because they have to delay retirement, sometimes for many years, because of this huge debt. And if they lose their home, and with a bit of an ironic twist, they may be moving in with their new college grad," Tilp says.

A related question is whether to tap equity to pay off a student's loans after he or she graduates.

That might seem smart, but Alan Moore, a CFP professional for Serenity Financial Consulting in Milwaukee, says parents shouldn't sacrifice their own financial well-being.

"Kids are much better off with financially secure parents than they are being financially secure and having to take care of their parents later in life," Moore says.

One exception might be if the parent (unwisely) co-signed a student's loans and the student didn't make the payments.

Maybe: Use Equity as Retirement Income

Some retirees use a HELOC to meet their current income needs in years when their investment returns aren't sufficient for that purpose, Tilp says.

But again, there's a risk because eventually the retiree will have to make payments on the HELOC.

"If their investment returns don't pick up, they'll need to cut back elsewhere or borrow more against the line of credit, which can start a dangerous downward spiral," Tilp warns.

Another option is a reverse mortgage, which allows seniors to borrow against home equity without making payments. Instead, the loan is repaid when the senior dies or moves out of the home or the home is sold.

Nope: Use Equity to Pay Off Credit Cards

Paying off car loans, credit cards or other personal debt is another popular use of a home equity loan, HELOC or cash-out refinance.

But the ease with which new debts can be incurred suggests this tactic might not always be wise.

"It may make sense when you run the numbers," Moore says. "But that doesn't cure the problem of credit card debt. We want to make sure we're taking care of what got you into debt in the first place."

Moore points out that credit card debt is unsecured while a home loan is secured by your home, which explains why the interest rate is so much lower than a typical credit card rate.

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